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9
FEATURE
Risk and return: some
footsteps into the
psychology of investment
Hamish McPhail LL.B AFA, CFPCM, GDipBus (Personal Financial Planning)
Medical Financial Advisory Services Ltd (MFAS)
There are two facets to any investment decision. If I put money into a long term
investment (and so forgo the ability to spend it now), what will my return be
and what is the risk?
Your active decision to delay current consumption for future consumption raises
interesting conundrums regarding regret minimisation. As US adviser Ben Carlson
posits “some investors will regret missing out on gains while others will regret
taking part in huge losses. Which regret will wear worse on your emotions?”
When navigating the investment pathway, all too often the focus is on return.
How often do you hear friends and colleagues boasting about the high return their
investment has made or will make? You will almost never hear those same people
stating that such returns are predicated from growth-orientated, thinly diversifed
investments with just as high a chance of failure as success.
A good investment proposition should always start with a thorough examination of
risk involved and next assess upside return. Why? Because simple mathematics tell
us that the consequences of losing money is going to far outweigh the pleasure of
making it!
Let’s look at a $100,000 investment that enjoys a particularly healthy 20% return in
a single year. Its value in 12 months becomes $120,000. That same investment faces
headwinds in the next year and loses what it has gained – 20%. The value does not
therefore fall back to $100,000 but rather becomes $96,000, 4% less than originally
committed.
Using the same example but transposing 50% as the yr1 gain/yr 2 loss we see
the investment peak at $150,000 and tumble in the second year to $75,000. This
would then require a 34% gain to restore back to the original $100,000 capital. As
an investor you are suddenly a long way behind the ballgame refecting the danger
of focussing on high risk investments without due consideration. (As a side note, it